The Development of the Federal Reserve

To guard against this possibility, bankers prior to the establishment of the Federal Reserve would establish lines of credit with larger banks. In the event of a run, the smaller bank would draw on the line of credit. The larger banks, or central banks, to keep shady small-time operators out of business, evaluated the line of credit.

Nobody would invest serious money to a small bank not protected against a run by a larger partner. However, the system was not perfect. In times of panic, large numbers of depositors would demand to withdraw their money. Only the largest Wall Street banks, with millions of dollars in reserve, could guard against this.Stories of bank runs- tales of people running to withdraw all their cash from their accounts- may seem dramatic, almost theatrical to people today. But to people living in an economically unstable society, like the early twentieth century, they were an expected occurrence.

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The banks were independent rivals, the amount of currency in circulation was fixed, and there was no element of trust between the depositor and the bank. The banks, in an attempt to avoid bank runs, were hoarding their money. However in order to hoard the money, they did not lend any out, bringing the economy to a standstill. The credit system of the country had ceased to operate, and thousands of firms went into bankruptcy. Something had to be done that would provide for a flexible amount of currency as well as provide cohesion between banks across the United States. A large regulated bank, like the Federal Reserve could make this happen. The Federal Reserve Act of 1913 helped to establish banks as a united force working for the people instead of independent agencies working against each other.

By providing a flexible amount of currency, banks did not have to hoard their money in fear of a bank run. Because of this, there was no competitive edge to see who could keep the most currency on hand and a more expansionary economy was possible. The evolution of the Federal Reserve did not begin on December 23, 1913 with the passage of the Federal Reserve Act. Rather, it began with the Banking Panic of 1907, the most severe of the four national banking panics that had occurred in the precious thirty-four years. During this time several large corporations and stock brokerages went bankrupt that summer.

Stock prices fell, causing traders to withdraw money from banks to cover their losses. There was a recession looming nationwide. It was a terrible situation that needed help or it could keep deteriorating and produce a panic far worse than any previous panics.

J.P. Morgan, the legendary founder of one of Wall Street’s largest investment banks, swung into action to meet the crisis. He assembled a team of bank and trust executives who met around the clock in Morgan’s library every day for three weeks. The men had every incentive to act forcefully. Their own businesses and vast fortunes were on the line. Under Morgan’s direction, the team redirected money from strong to weak banks, secured further lines of credit overseas, and bought stock in distressed but still sound corporations. Within a few weeks the panic passed, with only minimal effects on the country.

Morgan did not receive the thanks of a grateful nation. A House of Representatives committee investigated Morgan. Morgan, it turned out, had profited by his actions in saving the country.

The stocks he had purchased at fire sale prices had increased in value and this could not be tolerated. In response to this, a committee was established to find the flaws of the current banking system. This committee, the National Monetary Commission, found there were two main flaws dominating the system. First, the currency was not responsive to changes in demand. This meant that the bank had a fixed amount of currency, regardless of the demand for it. If people wanted to withdraw more money than the bank carried, then the bank had no way of providing the extra money. This led into the second problem of the bank, the fact that it was prone to panic. If people could not get their money out, then they panicked, and these panics drove banks out of business.

In 1913, Congress created the Federal Reserve System and converted central banking into a government monopoly. All nationally chartered banks were required to maintain reserves with a regional Federal Reserve Bank. The regional reserve banks would be managed not for profit but in the “public interest,” by political appointees.The Act divided the country into twelve districts, each district with its own banking “center.” The banks within each district were then divided up with respect to size, so that small banks, medium banks, and large banks all have the same voting power.

An appointed board of governors would oversee all bank operations within their respective districts, and the Federal Reserve would control the distribution of all currency. The Federal Reserve Act also required that all nationally chartered banks must be members of the Federal Reserve System. The bill passed through Congress with little difficulty, thanks to the Democratic stronghold in both houses, and President Wilson passed the act into law December 23, 1913. However, it was not met without criticism. It was said to have reflected the rooted dislike and distrust of banks and bankers that has been for many years and there should not be absolute political control over the business of banking. Despite some strong opposition it was made clear that although government influence would be present, it was designed to be free from personal or party politics.

The public, much quicker than Wilson had anticipated, as he described the Act as a constitution of peace for the private businesses of the nation, accepted the Act quickly.The Act was not perfect, however, and the last sentence of the Act states: “The right to amend, alter, or repeal this Act is hereby expressly reserved.” In fact, an overlying theme of the Federal Reserve Act was one of uncertainty; and many of the provisions used language like “under the rules and regulations to be specified by the Federal Reserve Board,” and “subject to review and determination of the Federal Reserve Board.” The rules had to be developed as the game was learned. Though not an ideal system, the Federal Reserve Act did solve the problem of a flexible currency. The Federal Reserve Act helped to stabilize the volatile banking system.

No longer were banks independent organizations working against each other. Now they were secure interrelated operations. The Federal Reserve Act worked because it eliminated the competition to hoard money between the banks and put the power into the hands of the government. Now, credit could be made available to expanding businesses, jobs could be created, and the banks would no longer have to worry about bank runs “running” them out of business.

Because of the Federal Reserve Act, the economy could once again become expansionary with confidence